Under normal circumstances, the decision of the ECB to raise interest rates by 0.25 per cent at a time when the European economy is slowing, and inflation seems to be peaking, would have been a very big deal. However, with the peripheral debt crisis still deteriorating, the rate increase has not really been the centrepiece of market attention today.
Instead, the main focus is on the composition of the ECB’s balance sheet, where a much larger, if slower moving, story is unfolding. The ECB is gradually being drawn into the “socialisation” of peripheral country debt, in ways which are completely outside the control of the central bank, and which could yet end in crisis.
Today, the ECB decided to continue accepting Portuguese debt as collateral for repo operations, even though Portugal has been downgraded by Moody’s this week. The ECB is increasingly taking actions which they would have deemed unthinkable two years ago. But they are trapped, and will remain trapped until there is a more comprehensive solution to the peripheral debt crisis.
The case for a rise in interest rates in the eurozone was discussed in this previous blog in April. This pointed out that the margin of cyclical unemployment in Europe is much smaller than it is in the US, which implies that the “correct” level for short rates (as indicated for example by the Taylor Rule) is higher in the case of the ECB than it is for the Fed. However, since April, industrial production in the global economy has slowed, and there has been a notable drop in eurozone consumers’ expenditure in Q2. In addition, inflation in the eurozone has stabilised, after a succession of disappointing data releases early in the year. Given this latest economic evidence, my own vote today would have been for no change in rates, but at least the ECB board has not indicated that any further rate rises are just around the corner.
All of this is, however, a sideshow compared with what is happening to the ECB’s balance sheet. As the private financial market has progressively withdrawn funding from the banking systems of Greece, Ireland and Portugal, the ECB and its constituent national central banks have been sucked into replacing the lost capital on an increasingly alarming scale.
The banking sectors in the three most troubled economies have been unable to issue bonds with a maturity of greater than 12 months since the crisis blew up in 2010. Furthermore, the private repo market has largely dried up, implying that banks in the troubled economies have had to turn to the ECB as the only source of available liquidity.
All of this is now fairly familiar, but the important point is that it is still showing no sign of any improvement, even though the EU is preparing to release the latest round of emergency funding for Greece. Martin Wolf’s column explained in considerable detail yesterday why the European rescue operation has so far failed to persuade the government bond markets that the troubled economies are moving back towards solvency. In fact, it is the reverse.
The banking markets have drawn the same conclusion. The imposition of additional, increasingly onerous, fiscal tightening on chronically weak economies seems to be raising, rather than lowering, the market’s assessment of sovereign default risk. And that has made it harder to imagine any improvement in the private funding of the banks, which are large holders of sovereign debt, and need to use it as collateral in repo operations.
As a result, the ECB has had to provide open ended liquidity, or face the certain failure of the banking sectors in the peripheral countries. The ECB is now financing around 20 per cent of the balance sheets of Greek and Portuguese banks, and has a total exposure to the troubled economies in excess of €400bn. Not all of this would be ultimately written off in the event of sovereign defaults. But the capital and reserves of the European System of Central Banks is only €81bn, so recapitalisation of the central banks could easily become necessary. As a result, much of the risk which has been taken on by the ECB would be “socialised” or “communitised” across the taxpayers of the EMU nations.
As if that were not enough of a problem, there are signs of a further, and even less controllable, problem emerging. Ordinary bank depositors in Greece and Ireland are beginning to shift their money out of the retail banks. Fearful of bank failures, and/or the break-up of the euro followed by currency devaluations, people are either hoarding cash under the mattress, or seeking safer havens like bank accounts in Germany.
Nicola Mai of JP Morgan has produced a neat graph on the extent of this bank deposit flight, which is reproduced below:
Since the beginning of the crisis, the Greek and Irish banking institutions have lost about 15 per cent of their retail deposits. The consequence of this bank run is that the ECB has had to replace this source of bank funding as well. The pace of withdrawal of bank deposits in Greece and Ireland is not quite as fast as that which occurred during the Argentinian crisis in 2000-02, and has not shown any sign of recent acceleration, but it adds a volatile and unpredictable element to the crisis.
As the UK government found in the case of Northern Rock, the appearance of queues outside banks is one of the worst nightmares which a central bank can face. It has not happened in Europe – yet.
